Preparing for higher interest rates

The rotation has already begun

By

MarkCotton

NEW YORK (CBS.MW) - Economists are divided about when the Federal Reserve Board might start raising U.S. interest rates again, but investors aren't waiting around to find out.

No sooner did the central bank send a message to Wall Street on Jan. 28 that it is a step closer to raising rates for the first time in almost four years, then investors began selling bonds and bailing out of technology and financial stocks to focus their portfolios on securities that do better when rates are rising.

After three years of falling rates, and with the central bank's federal funds rate sitting at a 46-year low of 1 percent, investors now have a window of opportunity to refocus their strategies and their portfolios before the inevitable cycle of higher rates begins again.

With the Nasdaq Composite Average
$COMPQ
and the Dow Jones Industrial Average
DJIA, +0.35%
both having soared last year, analysts and strategists said there are several moves investors can make now to not only protect those gains, but to find new ways to profit in a rising-rate environment.

Technology will take a battering

When it comes to technology stocks, market players speak with one voice. The sector will look increasingly unattractive as the time for a rate hike nears, strategists said.

Barry Hyman, an independent strategist, said technology stocks, notably semiconductor companies, are increasingly viewed as cyclical, in that they rise quickly when economic growth is strong, and fall rapidly when growth is slowing down.

"Cyclicals are affected as they would be priced to peak earnings potential early in the bull market, and as interest rates rise, the assumption is that earnings momentum should slow," Hyman said. "Cyclical stocks should be sold into a mature bull market, hopefully in anticipation of rate hikes.'

A hint that technology stocks are perhaps beginning to see a sell-off in recent weeks can be seen in the performance of the Philadelphia Semiconductor
SOX, +1.28%
index since the start of the year compared with other non-technology industry indexes.

The index, which tracks performance of chip stocks, rose 76 percent in 2003 as the bull market took hold. But since the beginning of 2004, the index has slipped back around 2.9 percent.

In contrast, the Amex Pharmaceutical Index
$DRG
which monitors the performance of a sector traditionally seen as a defensive play, climbed only 12 percent in 2003. Since 2004 began, however, it has gained around 4.0 percent.

The Dow Jones consumer, non-cyclical index, which includes such sector heavyweights as Coca-Cola, Kraft and Colgate-Palmolive, has also risen about 1.5 percent in the year-to-date.

Paul Nolte, director of investments at Hinsdale Associates, said there was already a historical precedent for a retreat from technology stocks in the wake of an interest rate hike.

"The area that is most likely to correct, is usually the area that has run up the most," Nolte said. "That's why parallels are being drawn between today and 1999-2000, when technology and telecom were very dominant."

Once interest rates started climbing again in June 1999, "investors started to reallocate toward consumer stocks and utilities, which were very consistent in their earnings and paid a nice dividend."

Bailing out of banks

Outside technology, investors should be cautious about having too much of their cash in banks and other financial institutions, strategists said. Rising interest rates make it more difficult for banks to earn money by borrowing at low rates and lending at higher ones, otherwise known as spread income.

"If the yield curve flattens out, meaning short-term rates rise while longer-term rates either fall or stay the same, that would make it more difficult for banks to create spread income," said Michael Sheldon.

And when the specter of rising interest rates recedes, shares of banking stocks almost always react positively. The January employment report released on Friday showed only modest growth in job creation and banking stocks along with other interest-rate sensitive industries moved higher as investors gambled that a slack job market would stave off a rise in interest rates a little bit longer.

Mortgages rise, homebuilders suffer

Sheldon said homebuilders, another interest-rate sensitive sector, could also be hurt by a return to climbing rates.

"Homebuilding has been benefiting in the last several years from the dramatic decline in mortgage rates, and higher interest rates would make it less affordable for individuals to take out mortgages."

And with fewer people looking for mortgages, banks get hit again - another reason perhaps to stay clear of them in a higher interest rate environment.

Shares of building materials groups and home furnishing companies would also be knocked off balance by any slowdown in the housing market.

"When people aren't buying as many homes, they won't need to be furnishing them," said Sheldon. "And if interest rates on borrowing climb, consumers may also be less likely to take out credit card debt in order to purchase consumer durables like cars."

Nolte said fund managers might also make any portfolio adjustments based on the reasons behind the interest rate hike.

"If it is a fear of inflation that is behind the rise in rates, you are going to have to pare your fixed income investment and maybe rotate portfolios to the more basic industry sectors like metals, commodities, paper and forest products."

Nolte said that these industries, which deal in raw materials, can raise prices in an inflationary environment, and thus improve their bottom line.

Switching into bonds

Bonds may have taken a hit on speculation the Fed might be a step closer to raising rates, as their yields jumped in anticipation of higher rates. But those higher yields might also make bonds attractive to some investors in a rising rate environment.

Sheldon said some fund managers might have to consider switching some of their investments out of equities entirely and into bonds.

"Higher interest rates create competition for investment dollars. If you're an investor and you can get a bond which yields 5 percent vs. 3 percent, that would create more competition for stocks, because you would be able to pick up additional yield if you held an investment to maturity."

You've still got time

Now, if you haven't taken a second look at your investments since the Fed signaled it might raise interest rates, market professionals say you still have some time.

"There is a general feeling among investors that the economy probably needs to create 200,000 to 300,000 jobs per month for the next several months before the Fed takes any action on raising interest rates."

On Friday, the government reported that 112,000 jobs were created in January, below expectations but still the best month since December 2000. See full story.

To press home that point, Chicago Federal Reserve president Michael Moskow said that stronger U.S. growth will not be enough to offset economic slack "for some time," signaling a go-slow approach with interest rate hikes.

"The recent increase in demand and confidence is starting to show through in hiring," said Moskow in prepared remarks for delivery to a Chamber of Commerce group in South Bend, Ind. "But labor markets are still a key area of weakness. Employment has taken longer to pick up than we expected; even longer that it did following the previous recession of 1990-91, which was characterized as the "jobless recovery."

The Fed funds futures market, where bets are made on the date of the next rate hike, are currently pointing to a 56 percent chance of a rate hike in June, with a quasi certainty of higher rates by August. There is a 62 percent chance of a second rate increase by September. Interest rates are seen at 1.60 percent by the end of the year.

The odds of a 25-basis point rise in interest rates in June rose considerably, when the Fed abandoned its pledge to keep interest rates low "for a considerable period," on Jan. 28, and instead promised to simply be "patient."

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